Tuesday, April 26, 2011

Not A Good Hedge

Investors and traders that ever thought about a mechanical trading system may be familiar with Sharpe ratio and maximum drawdown. Both measure the risk associated to a system. While I have not decided yet whether to device a mechanical system on top of my fundamental ranking system, this is an interesting topic and I'd like to waste some of my spare time. Calculating Sharpe ratio takes a little bit more effort. But maximum drawdown I can simply eyeball on the chart, which is roughly more than 60%. Admittedly one has to have a super strong stomach to trade such a system.

Hedging is a technique adopted by professional investors to manage risk. Naturally I'm thinking to short the bottom ranked k stocks all the time as a hedge. Those stocks are on the other extreme and should constantly move lower. So by shorting the bottom ranked stock maybe I'll earn extra returns. I pulled out the data of the bottom 20 stocks. As shown in the chart below, they generated a negative return in the past 10 years. Looks good so far.

But when putting together with the top 20 stocks, the overall return is not pretty. I scrutinized the data and find out the problem. Below is the chart of the top 20, the bottom 20, and the hedged portfolio between November, 2007, around the top of last bull market, and present. Bottom 20 moved down in lock steps with top 20 during the 2008 bear market, providing a good hedge to the portfolio and reducing the drawdown from over 60% to about 20% (in the bear market). It is good, but it comes at a price. During the 2009 sizzling rally, bottom 20 moved up a lot faster. A rising tide lifts all boats, and it also lift all garbages, and garbages got lift sooner than boats. Only until recently the bottom 20 slowed down a little bit, and the hedged portfolio is catching up. But still, if you didn't notice, the hedged portfolio is in the negative territory since November, 2007, while both top 20 and bottom 20 are up more than 60% from previous top.

I shall admit that the chart didn't tell the whole story. Bottom 20 started to move down in mid 2006. So from mid 2006 till end of 2007, the hedged portfolio gained extra return. But is it a good hedge? It depends on which one you'd prefer between a 60%+ maximum draw down; and a 40%+ maximum drawdown and watching the entire market rally but your own portfolio plunge. I'd choose neither.

Graham in his early years adopted similar strategy: longing undervalued and shorting overvalued. But later on he focused on only the long part. I think I know the reason now.

And by the way, in my ETF ranking post, I suggested to long the top ranked sector ETF and short bottom ranked one to stay market neutral. Now it looks not a brilliant idea. Yes you are "neutral", but if your portfolio is not moving anywhere, neutral is not a good word.

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